Barriers to Entrepreneurship

Leora Klapper, Luc Laeven, and Raghuram Rajan

Policymakers in country after country are trying to implement policies that will foster entry.Take, for example, the debate in continental Europe on the lack of home-grown venturecapital for promoting new firm creation in high-tech industries. Yet many questions remainabout which government policies can help foster a business climate favorable toentrepreneurship. Our empirical analysis of more than 3 million firms in Europe confirmsthat bureaucratic entry regulations are neither benign nor welfare improving. Entryregulations hamper the creation of new firms, especially in industries that naturally shouldhave high entry. Value added per employee in such industries grows more slowly, and olderfirms are slower to expand and thus remain smaller. Such are the adverse effects of the lack ofcompetition from new entrants. Regulations beneficial to entrepreneurship are those thatimprove access to finance and protect property rights.

Some facts about entrepreneurship are striking. For instance, one might expect that Italy, with itsmyriad small firms, should have tremendous new firm creation (we use “new firm creation”,“entry”, and “entrepreneurship” interchangeably). Actually, new firms (up to 2 years of age) as aportion of the total number of firms is only 3.5%, compared to 13.5% on average for other Europeancountries in the G-7.

Our study suggests an explanation for such low levels of entry: the average direct cost of fulfillingthe bureaucratic regulations for setting up a new business in Italy is a huge 20% of per capita GNP,compared to the average of 10% for other European G-7 countries.

Entry rates higher in Eastern Europe

Our analysis is based on the Amadeus database, a new, comprehensive database on private andpublicly traded firms in 34 countries in Eastern and Western Europe. Having excluded countrieswith incomplete coverage and poor data quality, as well as certain industries (such as the agriculture,mining, utility, finance, and public sectors), we end up with a sample of almost 3.4 million firms in21 countries.

We find that the average share of new firms is 13.3%. This figure ranges from 19.2% in Lithuania to3.5% in Italy (see the table). Overall, the share of new firms in Eastern European countries is 15.7%,compared to 11.9% in Western Europe. This difference reflects the recent emergence of a largenumber of private firms in the transition economies.

The direct costs of setting up a new business, expressed as a percentage of per capita GNP in USdollars, vary from an excessive 86% in Hungary to just 1% in Finland and the UK, with the averageat 20%.

Most of the entering firms are small. Interestingly, we find a greater proportion of new, larger firmsin the Eastern European countries. This may reflect continued privatization and reincorporation oflarger state-owned firms following transition. On average, 63% of new firms have fewer than 10employees, 23% have 10-50 employees, 12% have 50-250 employees and 2% have more than 250employees. The largest new firms are likely to be existing firms that reincorporate following amerger or acquisition.

How do bureaucratic regulations affect entrepreneurship?

The early debate on corporations emphasized the possibility that crooks might register with littlecapital and dupe unsuspecting investors or consumers. According to this view, entry regulationsserve the public interest by preventing fraud. By contrast, a long literature from Adam Smith toJoseph Stigler describes regulations as devices to protect the private interests of industry incumbentsor regulators.

To address the problem of causality, i.e. the possibility that in countries with generally lowentrepreneurship people may not be sufficiently motivated to press for the repeal of archaicregulations, we focus on cross-industry, cross-country interaction effects. In particular, we testwhether entry is relatively lower in “naturally high entry” industries in countries with excessivebureaucratic regulations.

We therefore need to know what entry would look like if there were few artificial or infrastructuralbarriers to entry, such as rigid labor regulation or poor access to financing. Under the assumptionthat these barriers are low in the United States (entry costs in the U.S. are just 0.5% of per capitaGNP, compared to the European average of 20%), we would expect the rate of entry in an industryin the United States to be a good proxy for the “natural” propensity for entry in that industry. The“natural” propensity reflects technological barriers like economies of scale or incumbentorganizational efficiencies obtained from experience. Of course, there is a degree of heroism inassuming that entry in the United States does not suffer from artificial barriers. Nevertheless, all thatis important is that the rank ordering of entry in the U.S. corresponds to the rank ordering of naturalbarriers across industries and carries over to other countries.Both in Europe and the U.S., we find high entry rates in the computer and communicationsindustries and low entry rates in infrastructure-related sectors.

Findings: Barriers to entry slow down business growth

Growth in value added is relatively lower in naturally high-entry industries in a country withsubstantial bureaucratic barriers to entry. There may be two explanations for this finding: slowergrowth could be attributed to incumbents having more monopoly power and restricting quantities, orincumbents may be less efficient as they are less subject to the discipline of competition. We findevidence for the latter explanation: older firms in naturally high-entry industries grow relativelymore slowly in countries with high bureaucratic barriers, while the relative growth of young firms isindistinguishable. Since age should not affect the incentive to restrict quantities, older firms workingin a more competitive environment in countries with low entry barriers become relatively moreefficient and continue to grow.

As a suggestive comparison, we plot average value added for firms in different age groups for twocountries, high entry-barrier Italy and low entry-barrier United Kingdom. Across all industries, firmsstart out larger when young in Italy, but grow more slowly, such that firms in the United Kingdomare about twice as large by age ten. This suggests Italy has small firms not because there is too muchentry, but perhaps because there is too little!

Figure 3, Firm size and age, UK vs. Italy

It turns out that entry barriers are more effective in preventing firm creation in high-incomecountries, suggesting that their purpose is not to screen out the untrustworthy, or that low-incomecountries have other natural barriers that prevent firm creation. More interestingly, entry barriers areeffective in retarding entry only in the least corrupt countries, implying that their purpose may wellbe to protect incumbents and their rents.

Access to finance stimulates entry

Liquidity constraints hinder people from starting businesses, so entry rates should be lower incountries with less developed financial systems. We also expect that access to finance is especiallyimportant for new firms in industries that require a lot of external financing. Bank credit is likely tobe the most important form of financing for small firms but we also examine access to start-upcapital, such as supplier trade credit, and measures of banking and capital market development.

As predicted, entry is higher in industries that depend heavily on external finance in countries thathave better financial development. What is particularly interesting is that entry is relatively higher inindustries that depend on trade credit financing in countries with greater extension of trade credit,even after controlling for the traditional effects of financial development. Supplier credit turns out tobe an important aid to entrepreneurship.

Other regulations are important

There are other regulations and aspects of the business environment that might affect entry, such asprotection of intellectual property, labor regulations, and the effects of taxes. Our examinationreveals that:Labor regulation hampers entry in labor-intensive industries. The cost of compliance with regulations may inhibit entry through fixed components, which are costly for small businesses. Small firms may not be able to afford to keep their employees through downturns and thus might “underhire” in the face of strict labor regulations;

• Better property right protection in a country promotes entry in R&D-intensive industries.

New entrants that do not have the organizational structure, finance, or intellectual capital to create a significant first mover advantage and dissuade potential imitators might have a greater incentive to do research if they know it will be legally protected; and

• Entry is significantly higher in high-entry industries in countries where tax rates on

corporate income are much lower than those on personal income. That is, higher taxes work much as regulatory barriers.

Conclusions

Policy makers should note that competition has disciplinary effects that outweigh any possiblescreening benefits from entry restrictions. Moves to reduce bureaucratic entry regulations will helptheir countries. Interestingly, entry regulations especially hurt countries that are more developed andless corrupt, i.e. where existing entry regulations are most effectively enforced. This is an interestingexample of a situation where more advanced countries have “bad” institutions.

However, it is by no means obvious that the best way to encourage entry and competition is toeliminate all regulation. Regulations that expand access to finance and strengthen property rightshelp the creation of new firms, and their absence can be an effective entry barrier.

Leora Klapper is a senior economist at the Development Research Group of the World Bank. LucLaeven is a senior financial economist in the Financial Sector Department of the World Bank.Raghuram Rajan is the economic counselor and director of research at the International MonetaryFund. This paper’s findings, interpretations, and conclusions are entirely those of the authors anddo not necessarily represent the views of the World Bank, the IMF, their Executive Directors, or thecountries they represent. The full text of the paper can be viewed athttp://www.nber.org/papers/w10380.